The Impact of Credit Watch and Bond Rating Changes On Abnormal ST

Singapore Management University
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Dissertations and Teses Collection (Open Access) Dissertations and Teses
2008
Te Impact of Credit Watch and Bond Rating
Changes on Abnormal Stock Returns for Non-
USA Domiciled Corporations
Boon Ching Benjamin EE
Singapore Management University, benjamin.ee.2006@mf.smu.edu.sg
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Recommended Citation
EE, Boon Ching Benjamin. Te Impact of Credit Watch and Bond Rating Changes on Abnormal Stock Returns for Non-USA
Domiciled Corporations. (2008). Dissertations and Teses Collection (Open Access). .
Available at: htp://ink.library.smu.edu.sg/etd_coll/44
THE IMPACT OF CREDIT WATCH &
BOND RATING CHANGES ON ABNORMAL
STOCK RETURNS FOR NON-USA
DOMICILED CORPORATIONS

BENJAMIN EE

SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE DEGREE OF MASTER
OF SCIENCE IN FINANCE

SINGAPORE MANAGEMENT UNIVERSITY
2008

2

2008
Benjamin Ee
All Rights Reserved
3

THE IMPACT OF CREDIT WATCH AND BOND RATING CHANGES
ON ABNORMAL STOCK RETURNS FOR NON-USA DOMICILED
CORPORATIONS

BENJAMIN EE

i. ABSTRACT
In this paper, we investigate whether credit watches and bond rating
changes issued by Moodys and S&P Credit Rating Agencies provide significant
new information to investors for Non-USA domiciled corporations. We also
examine whether the stock related cumulative abnormal return (CAR) differs
according to the classification of the country of domicile (emerging or developed)
of the corporation, and varies by state of the local stock market during the time of
the rating event.

We find that on average, negative credit watches as well as long term
rating downgrades result in significant stock related CAR for Non-USA domiciled
4
corporations. However, positive credit watches and long term rating upgrades
generally do not result in significant stock related CAR. On average, we find that
negative credit watches result in a stock related CAR of -1.37% within the (-1, +1)
window centered around the watch issuance, while long term rating downgrades
result in a stock related CAR of -1.33% within the (-1, +1) window centered
around the downgrade. Developed markets generally exhibit a stronger reaction.
Negative watch in developed markets have a stock related CAR of -1.44%,
compared to only -0.88% for emerging markets. The picture is similar for long
term rating downgrades. Downgrades in developed markets have a stock related
CAR of -1.47%, compared to only -0.76% for emerging markets. This paper
provides evidence that credit rating agencies are able to provide new information
to investors outside of companies domiciled in the USA.
5

ACKNOWLEDGEMENT

I would like to express my gratitude to my thesis supervisor Professor
Chiraphol New Chiyachantana, PhD. His familiarity with the field, and insights
have been of great value to me. His patience, encouragements and guidance
have also provided a good foundation for this thesis.

I would also like to thank my thesis examiner Professor Jeremy Goh, PhD
for his kind inputs into the paper. His published works were a valuable guide and
framework for this thesis. Professor Gohs suggestions also provided valuable
pointers that have enhanced the rigor of this paper.

My warm thanks are due to Lee Yen Teik, Dai Yao, Martin Ying, Anusha
Pai, Greg Vargas and my other classmates from the SMU Masters of Finance
and Masters of Economics class of 07 and 08 who study, discuss and play with
me, and who have also provided many valuable tips, pointers, help and kind
words, and who have made this journey a most pleasant one.

I also wish to thank Ms Rozana Osman from the SMU Office of Research
for her guidance and patience, and for being always helpful and patient with all of
us.

6
I also wish to thank Randy Tan, Hui Meng, Sophianne Araib, Tan Hui
Chin, Clement Lim, Seak Khit, Jasmine Neo, Ming Leong, Siok Kheng and the
rest of my colleagues from the Ministry of National Development for their
encouragements.

Last but not least, I dedicate this to my family for their support and care.
7

TABLE OF CONTENTS
Abstract............................................................................................................3
Acknowledgement............................................................................................5
1. INTRODUCTION.......................................................................................9
2. LITERATURE REVIEW...........................................................................11
2.1 Value and Effect of Credit Ratings....................................................11
2.2 Differentiation of Downgrades by Deterioration in Firms Prospects and
Increase in Leverage..................................................................................14
3. Contribution of Current Study..................................................................15
3.1 Global Scope of Credit Watch & Bond Rating Changes ...................15
3.2 Differences in National Regulatory Contexts ....................................17
3.3 Effectiveness of Rating Methodology outside USA...........................18
3.4 Linkages between Credit Watch and Bond Rating Changes ............20
3.5 Summary of Significant Empirical Findings.......................................21
4. BACKGROUND.......................................................................................27
5. DATA SOURCES....................................................................................29
6. SAMPLE CHARACTERISTICS FOR CREDIT WATCH PLACEMENT AND
BOND RATING CHANGES ...........................................................................32
7. METHODOLOGY....................................................................................35
8. THE WELCH T-TEST..............................................................................37
8
9. INFORMATION CONTENT OF CREDIT WATCH PLACEMENT AND BOND
RATING CHANGES.......................................................................................39
9.1 Stock Related CAR for (-1, +1) for Entire Sample.............................39
9.2 Stock Related CAR for (-1, +1) by Economy Classification ..............42
9.3 Stock Related CAR for (-1, +1) by Linkage between Credit Watch and
Rating Change............................................................................................47
9.4 Stock Related CAR for (-1, +1) by Rating Band Transitions .............53
9.5 Stock Related CAR for (-1, +1) by State of Local Market..................56
10. PREANNOUNCEMENT TRADING EFFECTS........................................60
11. CROSS SECTIONAL ANALYSIS OF EXCESS STOCK RETURNS.......63
11.1 Explanatory Variables.......................................................................63
11.2 Expected Signs.................................................................................67
11.3 Regression Results...........................................................................70
11.4 Discussion of Insider Trading Prohibitions........................................74
11.5 Country Breakdowns ........................................................................78
12. CONCLUSION AND FUTURE DIRECTIONS .........................................81
13. BIBLIOGRAPHY......................................................................................84
APPENDIX A: The Behrens Fisher Problem...............................................89
9

1. INTRODUCTION
Credit rating agencies (CRAs) such as Moodys and Standard and Poors
play an important credit monitoring role within financial markets. Bond ratings
issued by these 2 agencies dominate the market, accounting for 90 95% of the
world market share
1
, and are used by investors to determine the credit
worthiness, and hence, required return on bond issues.

The number of credit watch and bond rating changes issued by CRAs for
companies domiciled outside of the USA has increased since 1990. From our
dataset, the annual frequency of issues on credit watch for companies domiciled
outside of the USA increased from 29 in 1992 to 330 in 2006. The annual
frequency of issues on long term rating changes increased from 86 in 1992 to
300 in 2006. Nevertheless, to the best of our knowledge, there has not been
any study that examines the informational value of bond rating changes for
corporations domiciled outside of the USA. Whether these ratings provide
significant informational value to investors therefore remains to be seen our
study seeks to determine this. We note that over 98.4% (or substantially all) of

1
Credit Ratings of Long Term Bonds. Hilliard Lyons
10
the events in our sample are therefore related to companies with equity traded
outside of the United States.
11
2. LITERATURE REVIEW
2.1 Value and Effect of Credit Ratings
The value of credit ratings have been debated within academic literature.
Ederington and Yawitz (1987) find that most ratings can be predicted from
publicly available information. Wakeman (1990) argue that rating agencies
summarize existing public information, lowering information costs, but not
expanding information availability. However, Jorion, Liu and Shi (2004) find that
the informational effects of downgrades and upgrades are greater in the post-FD
period (after 23 Oct 2000) because credit analysts at rating agencies still retain
access to confidential information that is no longer available to equity analysts.

The effect of credit rating changes issued by the CRAs have a mixed track
record within the academic literature. Prior work have used both bond and stock
prices to examine the effect of rating changes. Weinstein (1977) (monthly bond
returns) and Wakeman (1978) (monthly stock and weekly bond returns) do not
find a price reaction at the time of rating changes. Katz (1974) (monthly changes
in bond yields), Grier and Katz (1976) (average monthly bond prices) and
Ingram, Brooks and Copeland (1983) (monthly changes in municipal bond yields)
find significant bond price reactions. Griffin and Sanvicente (1982), Wansley and
12
Clauretie (1985), Cornell et al (1989) generally find a significant negative reaction
to bond downgrades. They do not generally find a significant reaction to
upgrades. Wansley and Clauretie (1985) and Holthausen and Leftwich (1986)
also observe significant negative returns prior to the actual downgrades.
Similarly, Ederington and Goh (1998) examine trends in earnings before and
after rating changes, and find that downgrades both precede and portent
declines in earnings. However, upgrades bear little relation to earnings (both
before and after).

Holthausen and Leftwich (1986) use a sample of 1,014 rating changes by
Moodys and S&P over the 1977 1982 period. They report a statistically
significant two-day abnormal average return of -2.66%. Other than Wansley and
Clauretie (1985) and Hand et el (1992), these papers examine only equity market
reactions. This is likely due to difficulty in obtaining reliable daily bond data.
Hand, Holthausen and Leftwich (1992) (daily data on bond and stock prices) find
significant excess bond returns for unexpected additions (using an expectations
model based on bond yields) to creditwatch, although stock returns are only
significant for additions to negative creditwatch. For rating changes, the paper
finds significant bond and stock price reaction to downgrades, but little evidence
13
on effect of upgrades on bond and stock prices. Dichev and Piotroski (2001) use
all of Moodys bond rating changes announcements from 1970 1997,
representing a larger sample of 4,727 observations. They also find a significant
three-day price effect of -1.97% for downgrades, and 0.48% for upgrades. Both
results are significant, partially due to the increased power from the sample size.

14
2.2 Differentiation of Downgrades by Deterioration in Firms Prospects
and Increase in Leverage

Goh and Ederington (1993) also categorize rating downgrades into those
that are due to a deterioration in the financial prospects of the firm, and those
that result from an increase in leverage. The authors find that the former have
negative implications for stockholders, while the latter, positive. The authors also
find that the first class of rating changes reflect the rating agencys (Moody, in
this case) projections of the firms future prospects, while the latter is based on
past leverage increases. Consequently, there is an observed significant negative
stock reaction to the first class of downgrades, but not the second.
15

3. CONTRIBUTION OF CURRENT STUDY
3.1 Global Scope of Credit Watch and Bond Rating Changes
The aforementioned studies are based on the effect of bond rating
changes and credit watch for companies that are domiciled (or incorporated) in
the United States (US). To the best of our knowledge, there has not been any
study on the effect of bond rating changes in international markets, outside of the
US. However, with the advent of globalization, many non-US corporations are
also turning to bond issuance as a means of raising capital. Consequently, the
number of bond rating and credit watch events issued by the S&P and Moodys
rating agencies on non-US domiciled companies have also increased. Within our
dataset, which reflects long-term bond rating changes as well as credit watches
for fixed interest rate bonds and debentures for non-USA domiciled firms
2

between May 1991 and Jul 2007 for both credit watch as well as long term
ratings, there are a total of 4,039 long-term bond rating events within the time
period under observation as well as 3,287 credit watch events. The number of
long-term bond rating events each year increased from 47 events per year in

2
Excluding bonds issued by Supra-National organisations (e.g. Asian Development Bank, IMF)
as well as bonds issued by governments.
16
1991 and 86 events per year in 1992 to 300 events per year in 2006. The
number of credit watches increased from 29 in 1992 to 330 in 2006.
17

3.2 Differences in National Regulatory Contexts
Equity reactions to bond rating changes and credit watches issued by S&P
and Moodys for non-US domiciled firms may differ from reactions by US
domiciled firms. As this is the first study focusing on non-US firms, it remains to
be established whether S&P and Moodys ratings and credit watches provide
significant new information for investors in the stock of non-US domiciled firms.

One reason for any differences is that corporate governance and
regulatory contexts vary globally. One prominent example is Regulation Fair
Disclosure (FD), which prohibits US domiciled firms from sharing private
information with stock analysts, amongst other parties; post Reg FD, US
domiciled firms are however still able to share private information with CRAs,
therefore resulting in bond ratings and credit watches having a greater relative
informational value over stock analysts upgrades / downgrades. While this
would tend to increase the post Reg FD stock price reaction to bond rating
changes / credit watches for US-domiciled firms, a similar effect may not be
present for non-US domiciled companies as Reg FD does not apply to firms that
are not regulated by the US Securities and Exchange Commission (SEC).
18

3.3 Effectiveness of Rating Methodology outside USA
Another reason is that it rating agencies need to establish an effective
relationship with the issuer in order to obtain non-public information for the rating
process. It remains to be seen whether S&P and Moodys have been able to
achieve this effectively with non-US domiciled firms. According to Jorion (2005),
rating agencies typically begin the process of ratings following a request by
corporations for ratings issuance in advance of issuing debt. Agencies then
assign a team with relevant industry expertise, and there is also one primary
analyst who takes the lead in making regular contact, establishing a relationship
with the issuer and overseeing the rating process. The actual ratings are based
on both public information (e.g. accounting ratios) and nonpublic information
(profit breakdowns, product plans, financial projections, etc). The efficacy of the
rating process may therefore vary between emerging and developed markets, as
rating agencies may take time to familiarize themselves with the operations,
organizational culture and senior management of firms in emerging markets.
Additionally, the composition of public information may differ between developed
and emerging markets. It is likely that more information is public in developed
markets because of more established regulatory authorities as well as deeper
19
capital markets. We therefore segregate our results by developed / emerging
markets, using the Morgan Stanley Capital Index country classification as a
guide.
20

3.4 Linkages between Credit Watch and Bond Rating Changes
Additionally, we also examine stock reactions after both credit watches
and long term bond rating changes, and also the difference between bond rating
changes that were previously foreshadowed by credit watches (collectively
termed expected bond rating changes), versus bond rating changes that were
not foreshadowed (collectively termed unexpected bond rating changes). To
the best of our knowledge, this is the first study of its kind that considers the
linkage between credit watch as well as bond rating changes. Our study is
otherwise global in nature, but excludes US-domiciled companies as there is
already a large volume of research on the impact of bond rating changes and
credit watches on these firms.
21
3.5 Summary of Significant Empirical Findings
We find that on average, negative credit watch as well as long term rating
downgrades induce significant stock price reactions over a (-1, +1) period with
day 0 being the event day itself. Negative credit watches induce an average
stock related CAR of -1.37% (t-statistic of 7.15) while long term rating
downgrades induce a reaction of -1.33% (t-statistic of 7.11) over the 3 day
period for the entire sample. The average stock-related CAR associated with
positive credit watch is 0.13% (t-statistic of 0.90) while the stock related CAR
associated with long term rating upgrades is 0.07% (t-statistic of 0.75). Both
stock-related CARs for positive credit watch and upgrades are not significant at
the 2.5% level of significance (1-tail test). Hence, it appears that negative events
result in a significant stock price reaction, while positive events do not.
Additionally, the act of being put on credit watch is itself an informative event.

We also find that stock-related CAR in developed markets is stronger than
stock-related CAR in emerging markets, for negative credit watch and long term
rating downgrades. Stock-related CAR associated with a negative credit watch
in developed markets is -1.44% (t-statistic of 6.79), compared to -0.88% for
negative credit watch in emerging markets (t-statistic of 2.27). Additionally,
22
stock-related CAR associated with long term ratings downgrades in developed
markets is 1.47% (t-statistic of 6.84), compared to only 0.76% (t-statistic of
2.08) for long term ratings downgrades in emerging markets. Regression
analysis (Table 13) confirms that being domiciled in a developed market results
in a more negative reaction to long term rating downgrades; reactions are more
negative by -1.11% on average, compared to companies domiciled in emerging
markets. Also, being domiciled in a developed market results in the reaction to
negative credit watch being more negative by -0.63% compared to emerging
markets.

The results for upgrades when partitioned between developed / emerging
markets are mixed and not significant at the 2.5% level of significance (1-tailed
test). Positive credit watch in developed markets result in a 0.10% stock-related
CAR, compared to 0.30% for emerging markets. Additionally, long term rating
upgrades in developed markets result in a 0.08% CAR, and a 0.03% CAR in
emerging markets.

Goh and Edderington (98) argue that good news is typically released
more readily by corporations relative to bad news. Hence, positive credit
23
watches / long term rating upgrades represent minimal new information to
investors compared to negative credit watches / long term rating downgrades.
This could explain why negative credit watches / downgrades result in a more
significant stock price reaction compared to positive credit watches / upgrades.

Moreover, the greater stock-related CAR to negative credit watches and
rating downgrades in developed markets compared to emerging markets
indicates that the credit watches and ratings generally provide investors with
more new information in developed markets. The greater efficacy of the ratings
process in developed markets may be due to enhanced disclosure standards;
rating agencies may base their decisions partially on publicly available
information, which are fed into proprietary models. Additionally, laws governing
insider trading / other corporate governance measures may be more stringent in
developed markets. Hence, information leakage in emerging markets may be
more pronounced, therefore resulting in a smaller reaction upon rating changes.

Furthermore, when the results are further segregated by whether the
credit watches are eventually resolved by long term rating changes (termed
informative credit watches and expected rating changes respectively), or not
24
resolved (termed uninformative credit watches, with unlinked rating changes
termed unexpected rating changes), we find that informative credit watches and
surprised rating changes generally have more significant reactions.

Informative negative credit watches in developed (emerging) markets
have an average reaction of 1.82% (-1.76%) during the 3 day window,
compared to 1.11% (-0.38%) for non-informative negative credit watches. The
t-statistics for uninformative negative credit watch in emerging markets are not
significant at the 2.5% level of significance. Additionally, surprise long term
ratings downgrades in developed (emerging) markets have an average reaction
of 2.09% (-0.85%) during the 3 day window, compared to 0.85% (-0.49%)
during the 3 day window for expected long term ratings downgrades. The t-
statistics for the emerging markets surprise and expected downgrades are not
significant. This may also be due to the smaller number of observations for
events in the emerging markets, which reduces the power of the test.

Positive credit watches / upgrades generally resulted in insignificant stock-
related CARs, except in the case of expected long term rating upgrades in
emerging markets, which resulted in an average reaction of 1.33% (t-statistic of
25
2.86 significant at the 2.5% level of significance). This is likely due to the fact
that most of the rating events in this category occurred during months where the
broader stock indices for those countries exhibited strongly positive returns. The
average MSCI country index return during expected long term rating upgrades in
emerging markets was 2.23%, compared to 1.13% on average for all long term
rating upgrades. We subsequently demonstrate that the local MSCI country
index return has a significant impact on the returns associated with long term
rating upgrades but not with long term rating downgrades. A 1 percentage pt
increase in local MSCI country index return results in an additional 3.89%
percentage pt increase in stock-related CAR after long term rating upgrades.
The effect is not significant for bond downgrades. An explanation for this is that
investors consider the broader macroeconomic context in tempering CRAs
opinion of a corporations improved prospects going forward. However, they
react negatively to news of a corporations declining prospects regardless of how
the economy is performing, indicating that investors may assume the worst
after long term rating downgrades.

The remainder of this study is organized as follows. Section 4 - 6
describes background to credit rating agencies, data and sample characteristics,
26
Section 7 - 8 discussed the empirical methodologies and the Welch t-test which
we use to compare sample means, Section 9 presents overall empirical findings
and also partitions results by various characteristics (e.g. country of domicile,
etc), Section 10 investigates the possibility of insider trading by examining
preannouncement trading effects, Section 11 performs cross section analysis
and further discusses the possibility of insider trading, and lastly, Section 12
provides concluding remarks and future directions for research.
27

4. BACKGROUND

Table 1 shows the distribution of bond rating changes released by the 2
major rating agencies, Moodys and S&P. Together, these 2 agencies account
for over 90 95% of the global market. The table shows long term bond ratings,
which also incorporates the rating agencies opinion of the firms future
prospects. The ratings range from Aaa (for Moodys) and AAA (for S&P), which
denotes the most credit worthy issues, to C (for Moodys) and D (for S&P) for the
least credit worthy issues (already in default).

There are 2 main bands of ratings, investment grade and non-investment
grade. The bandings are significant because the yield to maturity required of the
issues increase dramatically between rating bands. Additionally, some pension /
mutual funds and other investment houses may be prohibited by their mandates
from holding non-investment grade rated debt, or prohibited from holding equity
in firms that are non-investment grade rated. The lowest investment grade rating
is Baa3 for Moodys and BBB- for S&P.

28
Table 1
Moodys S&P
Aaa AAA Highest Investment Grade 1
Aa1 AA+ High Investment Grade 2
Aa2 AA High Investment Grade 3
Aa NA High Investment Grade 3
Aa3 AA- High Investment Grade 4
A1 A+ Upper Investment Grade 5
A2 A Upper Investment Grade 6
A NA Upper Investment Grade 6
A3 A- Upper Investment Grade 7
Baa1 BBB+ Medium Investment Grade 8
Baa2 BBB Medium Investment Grade 9
Baa NA Medium Investment Grade 9
Baa3 BBB- Medium Investment Grade 10
Ba1 BB+ Lower Speculative 11
Ba2 BB Lower Speculative 12
Ba NA Lower Speculative 12
Ba3 BB- Lower Speculative 13
B1 B+ Spec Speculative 14
B NA Spec Speculative 14
B2 B Spec Speculative 15
B3 B- Spec Speculative 16
Caa NA Poor Speculative 16
Caa1 CCC+ Poor Speculative 17
Caa2 CCC Poor Speculative 18
Caa3 CCC- Poor Speculative 19
Ca CC Hspec Speculative 20
C C Lowest Speculative 21
NA D Def Speculative 23
The list of bond ratings released by Moodys and S&P are mapped to
ordinal values based on equivalence classes between the 2 rating
agencies.
Rating Agency
Type of Rating Band Ordinal Value

29

5. DATA SOURCES
We use four databases in the current study: S&P Rating Changes
database, Moodys Default Risk Service database, Bloomberg Investors Service
and daily stock price data from DataStream.

Specifically, we have access to a large sample of credit watch placements
(from May 1991 to Jul 2007) and bond rating changes (from Apr 1982 to Jul
2007) from Moodys Default Risk Service database, and also S&P Rating
Changes database. Both databases provide information on the beginning date
and credit watch indications of a bond (i.e. at the issue level) as well as
subsequent long term rating changes dates, and also the specific ratings. We
confine our sample to fixed rate non-ABS/CDO bonds issued by companies (i.e.
excluding sovereign and supra-national entities such as the Asia Development
Bank, the International Monetary Fund, etc) domiciled outside the US, and
examine only positive / negative credit watches, as well as upgrades /
downgrades for long term rating changes. Over 98.4% (or substantially all) of the
events in our sample are therefore related to companies with equity traded
outside of the United States.
30

Secondly, we map the bond ISINs
3
to stock ISINs for the parent
companies involved by using Bloomberg Investors Service. The parent
companies stock ISIN is then used to retrieve daily stock price history from
DataStream. In total, over 919 unique companies are considered in our analysis.
Companies without bond to stock ISIN mapping in Bloomberg Investors Service,
or without price data history available in DataStream are not considered.

In cases where credit watches are issued for several of a companys
bonds on the same day, we consider this as only one observation. Similarly,
where several of a companys bonds are issued with upgrades / downgrades on
the same day, we also consider this as a single observation. In cases where
some of a companys bonds experience expected rating changes, while others
do not on the same day, we consider the stock-related CAR as due to an
expected rating change. Thirdly, for the case where multiple bond rating
changes related to the same issuer happen on the same day, we consider the

3
An International Securities Identifying Number (ISIN) uniquely identifies a security (e.g bond /
stock) with a structure as outlined in ISO 6166. ISINs may cover bonds, commercial paper,
equities and warrants. The general structure of the ISIN code is a 12-character alpha-numerical
code that does not contain information regarding the characteristics of the financial instrument but
serves for uniform identification of a security at trading and settlement.

31
issue with the highest rating change magnitude, as this particular issue is likely to
impact stock prices the most.
32

6. SAMPLE CHARACTERISTICS FOR CREDIT WATCH
PLACEMENT AND BOND RATING CHANGES

Table 2 reports statistics on the number of credit watch placements and
bond rating changes. Table 3 reports the breakdown of informative /
uninformative credit watches, and expected / unexpected rating changes. We
note that the number of rating changes as well as credit watches for international
firms have increased steadily over time. The annual frequency of issues on
credit watch increased from 29 in 1992 to 330 in 2006. The annual frequency of
issues on long term rating changes increased from 86 in 1992 to 300 in 2006.
Additionally, the total number of credit watches and bond rating changes are
negatively skewed. Of the total sample, 73.7% (60.3%) are negative watches
(bond downgrades). 30.0% (44.7%) of long term rating upgrades (downgrades)
are preceded by a positive (negative) credit watch. Also, 51.9% (44.9%) of
positive (negative) watches are resolved by upgrades (downgrades).

33
Year
Number of
Upgrades
Number of
Downgrades
Number of
Positive Watches
Number of
Negative Watches
Total
1991 0 28 0 1 29
1992 2 84 0 29 115
1993 7 75 7 52 141
1994 19 39 9 29 96
1995 38 53 19 58 168
1996 54 45 25 62 186
1997 76 138 52 163 429
1998 70 272 55 341 738
1999 94 202 67 200 563
2000 131 147 88 186 552
2001 119 396 60 316 891
2002 99 346 47 258 750
2003 103 221 55 174 553
2004 184 104 99 125 512
2005 253 104 94 132 583
2006 179 122 126 204 631
2007
(until Jul) 176 59 61 93
389
Total 1,604 2,435 864 2,423 7,326
The combined sample of long term rating changes and credit watches from both Moody's Investor's Service and S&P
Rating Agency from 1991 to 2007 for companies domiciled outside the United States is given below. Only fixed rate
bonds issued by corporations (i.e. excluding sovereign bonds and supranational organisations) are considered. For
cases where a corporation has several rating events / credit watches on the same day, only 1 event is considered - for
rating changes, this is the event with the largest rating change magnitude. The sample in 1991 begins from May, and
ends in Jul in 2007.
Distribution of Long Term Rating Changes and Credit Watches from Moody's Investor's Service and
S&P Rating Agency for a Sample of 1604 upgrades, 2435 downgrades, 864 positive watches and 2423
negative watches from 1991 to 2007
Table 2

34
Fig 1: Number of Rating Events from Moodys and S&P for Non-US Domiciled
Companies
Fig 1 - Number of Rating Events from Moodys and S&P for Non-US Domiciled Companies
0
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Number of
Downgrades
Number of
Positive Watches
Number of
Negative Watches

Panel A:
Positive
Watch
Negative
Watch
Total
449 1,088 1,537
415 1,335 1,750
864 2,423 3,287
Panel B: Upgrades Downgrades
449 1,088 1,537
1,155 1,347 2,502
1,604 2,435 4,039
Table 3
Total:
Total:
Informative Credit Watches:
Uninformative Credit Watches:
Expected Rating Changes:
Unexpected Rating Changes:
Informative Credit Watches are defined as either negative credit watches that are resolved by a long term rating downgrade, or positive
credit watches that are resolved by a long term rating upgrade within a year. Conversely, uninformative credit watches are not resolved
by a long term rating change in the correct direction, and unexpected rating changes are not preceded by a corresponding credit watch.
In the case where only some of the bonds associated with a stock experience an 'expected' downgrade or upgrade on a particular day
while other bonds that are downgraded or upgraded on the same day are not preceded by credit watches, the long term rating event for
that stock is classfied as "expected"
Distribution of Informative / Uninformative Credit Watches and Expected / Unexpected Long Term
Rating Changes

35

7. METHODOLOGY

We present our empirical findings in 3 stages. First, we examine overall
stock-related CAR arising from the companys bonds being included on credit
watch and subsequent bond rating changes. This allows us to compare our
findings to prior research on US firms, and also test for significance in the market
reactions to credit watch emplacement and bond rating changes.

Secondly, we present different partitions for our results specifically, we
analyze the stock-related CAR to credit watch emplacements and bond rating
changes according to classification of country of domicile (whether developed or
emerging, according to the Morgan Stanley Capital Index classification), and
whether the credit watch / bond rating change is linked or unlinked. Additionally,
we also compare stock related CAR for rating change events that result in a
change in rating bands (i.e. from investment grade to non-investment grade, and
vice versa) with rating change events that do not result in a change in rating
bands. We also compare stock related CAR by state of the countrys MSCI index
(up or down) to determine if CAR varies according to the state of the broader
36
market. To the best of our knowledge, this latter partition has not been
attempted by prior literature. As a robustness check, we also examine
consistency of our results at the country level.

Thirdly, we utilize cross sectional regressions to determine the
significance of various variables in explaining stock related CAR to credit
watches and bond rating changes.

37

8. THE WELCH T - TEST

In order to test for significant differences between sample means, we use
the Welch t test, which is intended for use with two samples that may have
unequal variances. The Welch t test is therefore an approximate solution to the
Behrens-Fisher problem
4
, which is the problem of hypothesis testing of the
difference between the means of separate normally distributed independent
populations where the variances of the populations are not assumed to be equal.

The t statistic is therefore defined by the following formula:
=
2 1
2 1
2
1
N N
S
X X
t
s
s
s

The degrees of freedom v associated with this variance estimate is also
approximated using the Welch-Satterthwaite equation:

4
See Appendix A
38
2
2
2
4
2
1
2
1
4
1
2
2
2
2
1
. .
2 1
v N
s
v N
s
N
s
N
s
v
+
+
=
The statistics are then used with the t-distribution to test the null
hypothesis that the two means are equal.

39

9 INFORMATION CONTENT OF CREDIT WATCH
PLACEMENT AND BOND RATING CHANGES

9.1 Stock Related CAR for (-1, +1) for Entire Sample

In order to determine whether credit watch emplacements as well as long
term rating changes are informative events, we examine stock related CAR for a
3 day (-1, +1) window around the events using a standard event study
methodology.

Culmulative Abnormal Returns (CARs) are calculated as the cumulative
difference between the daily raw stock return and the concurrent local market
index for each of the 42 countries in our sample, as defined in DataStream. As a
robustness check, we also repeat all analyses using an alternative window period
of (-3, +3). The choice of event window does not appear to alter the significance
of our results.
40
Event Type
Avg Stock Related
CAR in (-1, +1)
t-statistic
# of
observations
Negative Credit Watch -1.37% -7.15 2,423
Positive Credit Watch 0.13% 0.90 864
Long Term Rating Downgrade -1.33% -7.11 2,435
Long Term Rating Upgrade 0.07% 0.75 1,604
Total: 7,326
Table 4
Average Stock Related Culmulative Abnormal Return (CAR) for 3 day period in window (-1, +1) centered around the
credit event at day 0 is calculated as the difference between the daily raw stock return and the concurrent local market
index (as defined in DataStream).
Average Stock Related CAR for (-1, +1) for Entire Sample for Positive / Negative Credit
Watch and Long Term Rating Upgrade / Downgrades

Fig 2: Stock Related CAR for Entire Sample
Stock Related CAR for Entire Sample
-1.6
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
Positive Credit Watch Negative Credit Watch Long Term Rating Upgrade Long Term Rating Downgrade
S
t
o
c
k

R
e
l
a
t
e
d

C
A
R

i
n

%

In Table 4 (also show in Fig 2), we consider four subsets of our sample.
These are positive / negative credit watch placements, and long term bond rating
upgrades / downgrades. If bond rating agencies are able to provide new
information to investors through credit watch placements or long term bond rating
41
events, then we should observe a significant stock-related CAR corresponding to
the credit watches / rating events. We find that stock-related CAR to negative
credit watch and bond rating downgrades are statistically significant. CAR
associated with negative credit watch is statistically significant at 1.37% (t-
statistic of 7.15). CAR associated with bond rating downgrades are also
statistically significant at 1.33% (t-statistic of 7.11).

Conversely CAR associated with upgrades are generally not significant.
There is only a 0.13% CAR associated with positive credit watch, and a 0.07 %
CAR associated with bond rating upgrades (both with t-statistics that are not
significant at the 2.5% level of significance). Our findings are consistent with the
bulk of academic literature on bond rating changes, e.g. Hand, Holthausen &
Leftwich (1992), Goh & Ederington (1993 and 1998) and Hite & Warga (1997),
which find that on the whole, bond rating downgrades are significant, while bond
rating upgrades do not result in a significant price reaction, and therefore by
extension, are not informative. One possible explanation for this is that firms
tend to disseminate good news aggressively, while withholding bad news; hence,
a bond rating downgrade provides more new information to investors (see Goh &
Ederington, 1993).
42
9.2 Stock Related CAR for (-1, +1) by Economy Classification

Avg Stock Related
CAR in (-1, +1)
t-statistic
# of
observations
Negative Credit Watch
(Developed Markets)
-1.44% -6.79 2,105
(Emerging Markets)
-0.88% -2.27 318
Welch t-test for difference
in sample means
t-statistic = 1.2521
df = 524
Positive Credit Watch
(Developed Markets)
0.10% 0.70 770
(Emerging Markets)
0.30% 0.76 94
in sample means
df = 121
Total: 3,287
Table 5
Average Stock Related CAR for (-1, +1) for Entire Sample of Positive / Negative Credit
Watches partitioned by Classification of Country of Domicile

43
Fig 3: Stock Related CAR for Credit Watch by Classification of Economy
Stock Related CAR for Credit Watch
-1.60%
-1.40%
-1.20%
-1.00%
-0.80%
-0.60%
-0.40%
-0.20%
0.00%
0.20%
0.40%
(Developed Markets)
(Emerging Markets)
(Developed Markets)
(Emerging Markets)
%

C
A
R

Comparing market reactions to negative credit watch emplacement and
bond rating downgrades between developed markets and emerging markets in
Table 5, we find that developed markets generally exhibit a larger reaction to
negative credit watch and bond rating downgrades compared to emerging
markets. Developed markets have an average stock-related CAR of -1.44% (t-
statistic of 6.79) for negative credit watch emplacements, compared to only -
0.88% (t-statistic of 2.27) for emerging markets. Additionally, developed
44
markets have an average stock related CAR of -1.47% (t-statistic of 6.84) for
bond rating downgrades, compared to only -0.76% (t-statistic of 2.08) for
emerging markets (Table 6). Results for positive credit watch / upgrades when
segregated by classification of economy are not significant. These results
indicate that rating agencies announcements for companies domiciled in
developed markets carry greater new information content compared to
announcements related to companies domiciled in emerging markets. This could
be due to greater information leakage in emerging markets due to fewer
restrictions against insider trading, etc. We investigate preannouncement trading
effects as a proxy of insider trading in subsequent sections.

45
Avg Stock Related
CAR in (-1, +1)
t-statistic
# of
observations
Long Term Rating Downgrade
(Developed Markets)
-1.47% -6.836782681 1,954
Long Term Rating Downgrade
(Emerging Markets)
-0.76% -2.083303349 481
in sample means
df = 848
Long Term Rating Upgrade
(Developed Markets)
0.08% 0.774759269 1,205
(Emerging Markets)
0.03% 0.147906626 399
in sample means
df = 690
Total: 4,039
Table 6
Average Stock Related CAR for (-1, +1) for Entire Sample of Long Term Rating Upgrades /
Downgrades partitioned by Classification of Country of Domicile

46
Fig 4: Stock Related CAR for Rating Change by Classification of Economy
Stock Related CAR for Rating Change
-1.60%
-1.40%
-1.20%
-1.00%
-0.80%
-0.60%
-0.40%
-0.20%
0.00%
0.20%
Long Term Rating
Upgrade (Developed
Markets)
Long Term Rating
Upgrade (Emerging
Markets)
Long Term Rating
Downgrade (Developed
Markets)
Long Term Rating
Downgrade (Emerging
Markets)
%

C
A
R

47
9.3 Stock Related CAR for (-1, +1) by Linkage between CW and RC

Table 7 and 8 reports results that are additionally segregated by
informative / uninformative credit watch, and expected / unexpected bond rating
changes. Our results indicate that being put on credit watch is an effective tool to
reduce stock price volatility around actual bond rating changes. In developed
markets, the stock related CAR surrounding a surprise long term rating
downgrade is -2.09%, compared to -0.85% in the case of an expected long term
rating downgrade. Similarly, for emerging markets, the stock related CAR
surrounding a surprise long term rating downgrade is -0.85%, compared to -
0.49% for expected long term rating downgrades (t-statistics for the emerging
market average reactions are not significant at the 2.5% level of significance).
The maller difference for emerging markets could be that information leakage
has reduced the informational advantage that unexpected downgrades have over
expected downgrades.
48
Event Type
Average Stock Related CAR
(t-statistics in parantheses)
# of observations
Surprise Long Term Downgrades
-1.76%
(-5.97)
1,347
Expected Long Term Downgrades
-0.81%
(-3.89)
1,088
Welch t-test for difference in
sample means
df = 2312
Surprise Long Term Upgrades
0.02%
(0.18)
1,155
Expected Long Term Upgrades
0.19%
(1.28)
449
sample means
df = 974
(Developed Markets)
-2.09%
(-5.74)
983
(Developed Markets)
-0.85%
(-3.75)
971
sample means
df = 1636
(Emerging Markets)
-0.85%
(-1.85)
364
(Emerging Markets)
-0.49%
(-1.06)
117
sample means
df = 343
(Developed Markets)
0.12%
(0.92)
824
(Developed Markets)
-0.01%
(-0.08)
381
sample means
df = 950
(Emerging Markets)
-0.24%
(-1.26)
331
(Emerging Markets)
1.33%
(2.86)
68
sample means
df = 91
Total: 4,039
Average Stock Related CAR for 3 day period in window (-1, +1) centered around long term rating event on
day 0 partitioned by whether the rating event was preceded by a credit watch or not in the correct direction
within a year.
Average Stock Related CAR for Entire Sample, Partitioned by whether Rating
Change is Surprised or Expected (i.e. preceded by corresponding credit watch)
Table 7
Panel C: Upgrades by Market Type
Panel A: Overall Sample
Panel B: Downgrades by Market Type

49
Event Type
Average Stock Related CAR
(t-statistics in parantheses)
# of observations
Informative Negative Credit Watch
-1.81%
(-6.61)
1,088
Uninformative Negative Credit Watch
-1.00%
(-3.79)
1,335
sample means
df = 2377
Informative Positive Credit Watch
0.14%
(0.75)
449
Uninformative Positive Credit Watch
0.11%
(0.52)
415
sample means
df = 840
(Developed Markets)
-1.82%
(-6.15)
972
(Developed Markets)
-1.11%
(-3.71)
1,133
sample means
df = 2096
(Emerging Markets)
-1.76%
(-2.55)
116
(Emerging Markets)
-0.38%
(-0.81)
202
sample means
df = 217
(Developed Markets)
0.08%
(0.38)
381
(Developed Markets)
0.13%
(0.60)
389
sample means
df = 763
(Emerging Markets)
0.49%
(1.02)
68
(Emerging Markets)
-0.21%
(-0.32)
26
sample means
df = 53
Total: 3,287
Panel C: Positive Watch
Panel B: Negative Watch
Table 8
Average Stock Related CAR for Entire Sample, Partitioned by whether Credit
Watch was Informative or Uninformative
Average Stock Related CAR for 3 day period in window (-1, +1) centered around credit watch on day 0
partitioned by whether the credit watch was resolved by a rating event or not in the correct direction within
a year.

50
Fig 5: Stock Related CAR for Credit Watch by Informativeness
Stock Related CAR for Credit Watch
-2
-1.5
-1
-0.5
0
0.5
1
I
n
f
o
r
m
a
t
i
v
e

P
o
s
i
t
i
v
e
(
D
e
v
e
l
o
p
e
d
)
I
n
f
o
r
m
a
t
i
v
e

P
o
s
i
t
i
v
e
(
E
m
e
r
g
i
n
g
)
U
n
i
n
f
o
r
m
a
t
i
v
e
P
o
s
i
t
i
v
e
(
D
e
v
e
l
o
p
e
d
)
U
n
i
n
f
o
r
m
a
t
i
v
e
P
o
s
i
t
i
v
e

(
E
m
e
r
g
i
n
g
)
I
n
f
o
r
m
a
t
i
v
e

N
e
g
a
t
i
v
e

(
D
e
v
e
l
o
p
e
d
)
I
n
f
o
r
m
a
t
i
v
e

N
e
g
a
t
i
v
e

(
E
m
e
r
g
i
n
g
)
U
n
i
n
f
o
r
m
a
t
i
v
e
N
e
g
a
t
i
v
e

(
D
e
v
e
l
o
p
e
d
)
U
n
i
n
f
o
r
m
a
t
i
v
e
N
e
g
a
t
i
v
e

(
E
m
e
r
g
i
n
g
)
%

C
A
R

51
Fig 6: Stock Related CAR for Rating Change by Linkage with CW
Stock Related CAR for Rating Changes
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
S
u
r
p
r
i
s
e

U
p
g
r
a
d
e
s
(
D
e
v
e
l
o
p
e
d
)
S
u
r
p
r
i
s
e

U
p
g
r
a
d
e
s
(
E
m
e
r
g
i
n
g
)
E
x
p
e
c
t
e
d

U
p
g
r
a
d
e
s
(
D
e
v
e
l
o
p
e
d
)
E
x
p
e
c
t
e
d

U
p
g
r
a
d
e
s
(
E
m
e
r
g
i
n
g
)
S
u
r
p
r
i
s
e

D
o
w
n
g
r
a
d
e
s
(
D
e
v
e
l
o
p
e
d
)
S
u
r
p
r
i
s
e

D
o
w
n
g
r
a
d
e
s
(
E
m
e
r
g
i
n
g
)
E
x
p
e
c
t
e
d

D
o
w
n
g
r
a
d
e
s
(
D
e
v
e
l
o
p
e
d
)
E
x
p
e
c
t
e
d

D
o
w
n
g
r
a
d
e
s
(
E
m
e
r
g
i
n
g
)
%

C
A
R

We note that the results for upgrades, segregated by expected or
unexpected are also not significant, except for the case of expected upgrades in
emerging markets. In developed markets, the stock related CAR surrounding an
expected long term rating upgrade is -0.01%, compared to 0.12% in the case of
an unexpected long term rating upgrade (t-statistics not significant at 2.5% level).
Similarly, for emerging markets, the stock related CAR surrounding an expected
long term rating upgrade is 1.33% (t-statistic of 2.86 is significant), compared to -
0.24% for unexpected long term rating upgrades. We note that the significant
52
results for expected upgrades in emerging markets may be due to the fact that a
majority of events in this category occur when the country MSCI indices exhibit
strongly positive returns. The average MSCI country index returns during the
month of expected upgrade events in emerging markets is 2.23%, compared to
1.13% on average for upgrades in general. Cross sectional regression analysis
(Table 13) shows that the state of the MSCI country index (as a proxy for the
macroeconomic environment in the corporations country of domicile) is
significant in explaining variation in reactions to upgrades in general. However,
the same variable is not significant in explaining variation in reactions to
downgrades. This could be because investors weigh the strength of a
corporations macroeconomic environment in tempering expectations of future
positive prospects by rating agencies.
53
9.4 Stock Related CAR for (-1, +1) by Rating Band Transitions

Event Type
Average Stock Related
CAR
(t-statistics in
parantheses)
# of observations
A1: Downgrades within Investment Grade
-0.30%
(-2.22)
1,297
A2: Downgrades to Speculative Grade
-2.01%
(-2.81)
271
A3: Downgrades within Speculative Grade
-2.67%
(-6.23)
867
Welch t-test for difference in sample means
between sample A1 and sample A2
df = 289
df = 478
A4: Upgrades within Investment Grade
-0.11%
(-1.30)
843
A5:Upgrades to Investment Grade
0.23%
(1.32)
222
A6: Upgrades within Speculative Grade
0.28%
(1.25)
539
df = 333
df = 732
Total: 4,039
B1: Downgrades within Investment Grade
-0.36%
(-2.66)
1,213
B2: Downgrades to Speculative Grade
-2.38%
(-2.63)
207
B3: Downgrades within Speculative Grade
-3.65%
(-5.84)
534
between sample B1 and sample B2
df = 215
df = 413
B4: Upgrades within Investment Grade
-0.07%
(-0.85)
747
B5: Upgrades to Investment Grade
0.02%
(0.08)
153
B6: Upgrades within Speculative Grade
0.50%
(1.48)
305
df = 216
df = 445
Total: 3,159
C1: Downgrades within Investment Grade
0.57%
(0.80)
84
C2: Downgrades to Speculative Grade
-0.82%
(-1.07)
64
C3: Downgrades within Speculative Grade
-1.08%
(-2.29)
333
between sample C1 and sample C2
df = 139
df = 117
C4: Upgrades within Investment Grade
-0.38%
(-1.42)
96
C5: Upgrades to Investment Grade
0.70%
(2.11)
69
C6: Upgrades within Speculative Grade
-0.01%
(-0.03)
234
df = 141
df = 163
Total: 880
Table 9
Panel B: Developed Markets
Panel C: Emerging Markets
Average Stock Related CAR for Long Term Rating Events for 3 day period in window (-1, +1) centered around
day 0 partitioned by whether the rating event results in a transition from investment grade to non-investment
grade (for downgrades), and vice versa for upgrades
Average Stock Related CAR for Long Term Rating Events, Partitioned by whether
Event results in an Investment Grade Transition

54
Fig 7: Stock Related CAR for Rating Change by Presence of Investment Grade
Transitions
Investment Grade Transitions vs Non Investment Grade Transitions
-3
-2
-2
-1
-1
0
1
Non Investment Grade Transition
Upgrades
Investment Grade Transition
Upgrades
Non Investment Grade Transition
Downgrades
Investment Grade Transition
Downgrades
%

C
A
R

Table 9 shows that rating downgrades which result in a change in rating
bands (i.e. from investment grade to non-investment grade) result in a stronger
stock-related CAR compared to rating changes. In developed markets, rating
downgrades that result in a change in rating bands (from investment grade to
non-investment grade) have an average stock-related CAR of -2.38%, compared
to -0.36% for rating downgrades that stay within the investment grade band (t-
statistics are 2.63 and 2.66 respectively). In emerging markets, rating
downgrades that result in a change to non-investment grade have an average
stock-related CAR of -0.82%, compared to 0.57% for rating downgrades that stay
55
within the investment grade band we note that for emerging markets, neither t-
statistic is significant at the 2.5% level of significance.

We note that these results are consistent with findings from US markets,
which show that downgrades within speculative grade result in the largest stock
related CAR compared to downgrades within investment grade, and from
investment grade to speculative grade. This is because the largest increases in
required yield to maturity of the bonds result from downgrades within the
speculative grade.

In developed markets, rating upgrades that result in a change in rating
bands have an average stock-related CAR of 0.02%, compared to -0.07% for
rating upgrades that stay within the investment grade band (both t-statistics are
not significant). In emerging markets, rating upgrades that result in a change in
rating bands have an average stock-related CAR of 0.70%, compared to -0.38%
for rating upgrades that stay within the investment grade band (the t-statistic for
upgrades that cross the investment grade band in emerging markets is
significant).
56
9.5 Stock Related CAR for (-1, +1) by State of Local Market

Event Type
CAR
(t-statistics in
parantheses)
# of observations
Downgrades in Down Local Market
-1.54%
(-4.92)
1,120
Downgrades in Up Local Market
-1.16%
(-5.20)
1,315
df = 2085
Upgrades in Down Local Market
0.01%
(-0.09)
619
Upgrades in Up Local Market
0.12%
(1.17)
985
df = 1067
Total: 4,039
Downgrades in Down Local Market -2.00%
(-5.26)
841
Downgrades in Up Local Market -1.08%
(-4.38)
1,113
df = 1496
Upgrades in Down Local Market 0.04%
(0.19)
464
Upgrades in Up Local Market 0.11%
(0.99)
741
df = 712
Total: 3,159
Downgrades in Down Local Market -0.15%
(-0.30)
279
Downgrades in Up Local Market -1.60%
(-3.14)
202
df = 466
Upgrades in Down Local Market -0.18%
(-0.73)
155
Upgrades in Up Local Market 0.16%
(0.63)
244
df = 381
Total: 880
Table 10
Average Stock Related CAR for Long Term Rating Events, Partitioned by whether
Event occurs in an "Up' local market, or "Down" local market
Average Stock Related CAR for long term rating events for 3 day period in window (-1, +1) centered around day 0
partitioned by whether the event occurs during an "up" local market or "down" local market

57
Event Type
CAR
(t-statistics in
parantheses)
# of observations
Negative Credit Watch in Down Local Market
-1.95%
(-5.90)
1,144
Negative Credit Watch in Up Local Market
-0.84%
(-4.06)
1,279
df = 1948
Positive Credit Watch in Down Local Market
-0.16%
(0.67)
331
Postive Credit Watch in Up Local Market
0.10%
(0.61)
533
df = 640
Total: 3,287
(Developed Markets)
-2.19%
(-5.75) 959
(Developed Markets)
-0.81%
(-3.66)
1146
df = 1572
(Developed Markets)
0.17%
(0.66)
289
Positive Credit Watch in Up Local Market
(Developed Markets)
0.06%
(0.36) 481
df = 560
Total: 2,875
(Emerging Markets)
-0.74%
(-1.37) 185
(Emerging Markets)
-1.08%
(-1.97)
133
df = 306
(Emerging Markets)
0.09%
(0.13)
42
Positive Credit Watch in Up Local Market
(Emerging Markets)
0.47%
(1.02) 52
df = 75
Total: 412
Table 11
Average Stock Related CAR for Credit Watch Events, Partitioned by whether Event
occurs in an "Up' local market, or "Down" local market
Average Stock Related CAR for credit watch events for 3 day period in window (-1, +1) centered around day 0
partitioned by whether the event occurs during an "up" local market or "down" local market

58
Fig 8: Stock Related CAR by State of the Local Market Index
Stock Related CAR by State of Market
-2.5
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Additionally, Table 10 & 11 shows that rating downgrades in developed
markets that occur during periods where the local MSCI country index is up
exhibit less negative returns. Rating downgrades in developed markets that
occur when the local MSCI country index is up have an average stock-related
CAR of -1.08%, compared to -2.00% when the index is down. The picture is not
as clear in emerging markets. Rating downgrades in emerging markets that
occur when the local MSCI country index is up have an average stock-related
CAR of -1.60%. As the average stock-related CAR of -0.15% when the index is
down is not significant (t-statistic of -0.30), there is no basis for making the same
59
comparison as with developed markets. As seen in table 10, none of the t-
statistics for the average stock-related CAR with upgrades are significant.
Negative Credit Watch in developed markets also exhibit a less negative stock
related CAR when the local MSCI index is up. Stock related CAR is 1.95% in a
down market, compared to 0.84% in an up market. All t-statistics are significant
at the 2.5% level of significance. For emerging markets, the stock related CAR
to negative credit watch in a down local market is not significant at the 2.5% level
of significance, so there is no basis for comparison.
60
10. PREANNOUNCEMENT TRADING EFFECTS

We note that there is some evidence of insider trading in both developed
and emerging markets for long term downgrades, with a greater
preannouncement effect in the form of negative abnormal returns in emerging
markets. Table 12 shows that in the -50 to -26 day window before a long term
ratings downgrade, developed (emerging) markets exhibit an average stock
related CAR of -2.35% (-2.79%). Both sets of averages have significant t-
statistics of -9.04 (-3.35). However, in the -25 to -1 day window before the
downgrade, emerging markets exhibit a much larger -3.42% abnormal CAR,
compared to only -1.84% for developed markets. Once again, both sets of t-
statistics are significant at -7.08 (-3.69).

The larger preannouncement reaction for emerging markets is also
verified by the Welch t-test, which has a t-statistic of 1.64 for the difference
between preannouncement reactions in the 2 class of markets in the -25 to -1
window. We also note that all the t-statistics for the preannouncement
announcements in (-50, -26) and (-25, -1) for both markets are significant. For
negative credit watch, we note that there is no basis for comparison of magnitude
61
of insider trading because the t-statistics for preannouncement effects in
emerging markets are all not significant.

62
Avg Stock Related CAR
in (-50, -26)
(t-statistic in
parantheses)
Avg Stock Related CAR
in (-25, -1)
(t-statistic in
parantheses)
# of observations
(Developed Markets)
-1.51%
(-6.91)
-1.95%
(-8.27) 2,087
(Emerging Markets)
-0.11%
(-0.16)
0.24%
(0.17) 302
in sample means
df = 363
df = 336
(Developed Markets)
-0.03%
(-0.12)
0.24%
(0.84) 743
(Emerging Markets)
-1.92
(-1.86)
-0.11
(-0.11) 88
in sample means
df = 100
df = 516
Total: 3,220*
Long Term Rating
Downgrade (Developed
Markets)
-2.35%
(-9.04)
-1.84%
(-7.08)
1,933
Long Term Rating
Downgrade (Emerging
Markets)
-2.79%
(-3.35)
-3.42%
(-3.69)
446
in sample means
df = 534
df = 516
(Developed Markets)
0.41%
(1.96)
0.26%
(1.25)
1,183
(Emerging Markets)
-0.35%
(-0.66)
0.11%
(0.22)
367
in sample means
df = 481
df = 102
Total: 3,929*
*not all obs in sample have preannouncement stock prices available
*not all obs in sample have preannouncement stock prices available
Table 12
Average Preannouncement Stock Related CAR for (-50, -26) and (-25, -1) for Entire Sample of Positive /
Negative Creditwatch and Long Term Rating Upgrades / Downgrades
Average Preannouncement Stock Related Culmulative Abnormal Return (CAR) for 2 periods, (-50, -26) & (-25, -1)
is calculated as the difference between the daily raw stock return and the concurrent local market index (as
defined in DataStream). We note that not all the observations in the previous samples have preannouncement
stock prices available.

63

11. CROSS SECTIONAL ANALYSIS OF EXCESS STOCK
RETURNS
11.1 Explanatory Variables

We estimate multivariate regressions to try to explain cross-sectional
variation in the stock-related CAR due to credit watch and bond rating changes.
Using the same methodology as Jorion (2004), Hand, Holthausen and Leftwich
(1992), etc, separate regressions are estimated for upgrades and downgrades.
The following variables are included in the regression:
1. Rating change magnitude, represented by a cardinal variable that
indicates the number of grades changed (with AAA having a score of 1,
and D having a score of 26), and the variable being new score old
score.
2. For rating changes, a dummy variable set to 1 if the rating change is not a
resolution of a prior credit watch. The criteria for resolution is that the
rating change is in the same direction as the credit watch, occurs within 1
year of the credit watch, and is the earliest rating change for that specific
64
bond after the credit watch. For credit watch, this is set to 1 if the credit
watch was informative.
3. For rating changes, a dummy variable set to 1 if the rating change moves
the bond into or out of investment grade.
4. A dummy variable set to 1 if the credit watch / rating change occurs to a
company domiciled in an developed market country, as defined in the
Morgan Stanley Capital Index classification.
5. The monthly return of the MSCI country index for the country of domicile
of the company during the month of the rating change.
6. Time lapse since the last rating change
7. Market capitalization of company during the credit watch / rating change.
8. A dummy variable set to 1 if the country enforces prohibitions against
insider trading i.e., the country has previously persecuted insider
trading.
9. An index score of Anti Director Provisions, as a proxy for shareholder
rights. This proxy of country level corporate governance provisions is
used as defined in Law and Finance, La Porta, Harvard University, 98.
The index is the sum of the following dummy variables (as defined and
reproduced from La Porta 98):
65
a. One share - one vote: Equals one if the Company Law or
Commercial Code of the country requires that ordinary shares
carry one vote per share, and zero otherwise. Equivalently, this
variable equals one when the law prohibits the existence of both
multiple-voting and non-voting ordinary shares and does not allow
firms to set a maximum number of votes per shareholder
irrespective of the number of shares she owns, and zero otherwise.
b. Proxy by mail: Equals one if the Company Law or Commercial
Code allows shareholders to mail their proxy vote to the firm, and
zero otherwise.
c. Shares not blocked before meeting: Equals one if the Company
Law or Commercial Code does not allow firms to require that
shareholders deposit their shares prior to a General Shareholders
Meeting thus preventing them from selling those shares for a
number of days, and zero otherwise.
d. Cumulative voting or proportional representation: Equals one if the
Company Law or Commercial Code allows shareholders to cast all
of their votes for one candidate standing for election to the board of
directors (cumulative voting) or if the Company Law or Commercial
66
Code allows a mechanism of proportional representation in the
board by which minority interests may name a proportional number
of directors to the board, and zero otherwise.
e. Oppressed minorities mechanism: Equals one if the Company Law
or Commercial Code grants minority shareholders either a judicial
venue to challenge the decisions of management or of the
assembly or the right to step out of the company by requiring the
company to purchase their shares when they object to certain
fundamental changes, such as mergers, assets dispositions and
changes in the articles of incorporation. The variable equals zero
otherwise. Minority shareholders are defined as those
shareholders who own 10 percent of share capital or less.
f. Preemptive rights: Equals one when the Company Law or
Commercial Code grants shareholders the first opportunity to buy
new issues of stock and this right can only be waved by a
shareholders vote, and zero otherwise.
67
11.2 Expected Signs

The stock-related CAR should be more positive depending on the number
of grades changed by the rating, and should also be smaller in absolute
magnitude for resolutions of a credit watch. Additionally, the absolute magnitude
of the rating change should also be larger for rating changes that moves the
bond across investment grades, if the bond is related to a company that is
domiciled in a developed country and if it has been longer since the last credit
watch / rating change (since the incremental amount of new information is
greater).

Market capitalization is also included in the model we hypothesize that
information availability on larger firms (by market capitalization) would be greater,
therefore reducing the informational value of assessments by credit rating
agencies. Additionally, the stock related CAR for observations in countries
where insider trading laws are enforced should be greater because there will be
less information leakage, therefore resulting in the credit event having greater
informational value.

68

Lastly, we hypothesize that the more rights shareholders have over the
firms management (as proxied by the anti director rights variable), the more
positive the reaction to all rating events should be. While rating events represent
(to some degree), the release of private information to investors, investors have
an increased capacity to take action and prevent management from acting
contrary to their interests.
69

3 Day Stock Related
CAR for Positive CW
t-statistic
3 Day Stock
Related CAR for
Negative CW
t-statistic
3 Day Stock
Related CAR for
Long Term
Upgrade
t-statistic
3 Day Stock
Related CAR for
Long Term
Downgrade
t-statistic
Dependent Variables
Intercept 0.010935686 1.199305909 -0.005486805 -0.538286329 -0.003191999 -0.724052857 -0.004611493 -0.4634405
Marketcap of Company in US
$Billions
3.25005E-12 0.56088607 6.19396E-12 0.978345961 -2.47176E-12 -0.931894101 1.10295E-11 1.8079253
Company is Domiciled in
Developed Market
-0.007038363 -1.022153037 -0.006256863 -0.805412774 0.001172058 0.430543861 -0.011118227 -1.7404421
Rating Change crosses
Investment Grade Boundary
- - - -
0.002698083 0.965929841 -0.01678223 -2.6114668
Surprised Rating Change - - - - -3.29546E-05 -0.016112677 -0.00447095 -1.0708853
Return of Local MSCI Country
Index
-0.000574349 -0.015981328 0.081633803 3.146301821 0.038899573 2.421862194 0.013415839 0.6201031
Rating Change Magnitude - - - -
0.000345362 0.56394421 1.44873E-05 0.0093546
Interval Since Last Rating
Change
6.24675E-07 0.163419916 7.54837E-06 1.687050207 -9.81837E-07 -0.517271074 1.20871E-05 2.9363613
Informative Credit Watch -0.000854063 -0.22437229 -0.000828463 -0.175801846 - - - -
Anti Director Rights -0.000400604 -0.33859153 -0.000678976 -0.509233845 0.000662591 0.9530569 -0.000563936 -0.3693984
Insider Trading Laws
Enforcement -0.002972361 -0.508222361 -0.004162292 -0.521063814 0.001265603 0.407668033 -0.003184623 -0.425067
Number of Observations 591 1,703 1,097 1,602
Adjusted R Square -0.008684848 0.00560917 0.000469852 0.01088287
R Square 0.003222055 0.009684542 0.008677673 0.016443179
Standard Error 0.041143432 0.079133616 0.030349699 0.079843862
Independent Variables
Table 13
CAR is the culmulative abnormal stock related return over the 3 day period (-1, +1). Informative Dummy, Developed Markets Dummy, Investment Grade Transition Dummy and Surprise Dummy are
dummy variable that are 1 if the credit watch is informative, if the observation is for a company domiciled in an developed markets country, if the rating change results in an investment grade transition,
and if the rating change is not foreshadowed by credit watch respectively. Contemporaneous MSCI Returns is the return on the MSCI country index for the country of domicile for the month of the rating
change. Interval Since Last Rating Change is the number of days since the last rating change event, and Rating Change Magnitude is the new rating score - the old rating score, with AAA having a score
of 1 and D having a score of 26. Anti Director rights is the index score on country level corporate governance provisions as defined in "Law and Finance", La Porta, with a higher score indicating better
corporate governance
CAR(rating change)j = B0 + B1(SURPRISE DUMMYj) + B2(DEVELOPED MARKETS DUMMYj) + B3(CONTEMPORANEOUS MSCI RETURNSj) + B4(MARKET CAPITALIZATIONj)
+ B5(INTERVAL SINCE LAST RATING CHANGEj) + B6(RATING CHANGE MAGNITUDEj) + B7(INVESTMENT GRADE TRANSITIONj) + B8(INSIDER TRADING LAWS
ENFORCEMENT) + B9 (ANTI DIRECTOR RIGHTS)
CAR(credit watch)j = B0 + B1(INFORMATIVE DUMMYj) + B2(DEVELOPED MARKETS DUMMYj) + B3(CONTEMPORANEOUS MSCI RETURNSj) + B4(MARKET
CAPITALIZATIONj) + B5(INTERVAL SINCE LAST RATING CHANGEj) + B6(INSIDER TRADING LAWS ENFORCEMENT) + B7(ANTIDIRECTOR RIGHTS)
Regression Tests on Excess Stock Returns for Companies with Credit Watch and Long Term Rating Changes by Moody's or Standard and Poor's from 1982 - 2007
70
11.3 Regression Results

The results in Table 13 shows that, for negative credit watch, there is a
more negative reaction in developed markets. In the regression used, the t-
statistic on the developed markets dummy variable is weakly significant at -
0.81, and the coefficient of -0.0063 implies that, holding all else constant, the
marginal effect of being domiciled in an emerging market decreases the stock-
related CAR from the negative credit watch by 0.63 percentage points (i.e., it is
more negative).

Additionally, the coefficient of 0.0816 on the local MSCI country index
returns implies that a 1% increase in the local contemporaneous (same month)
MSCI country index returns increases returns during a negative credit watch by
8.16% (i.e. the stock-related CAR is less negative). Lastly, although the t-
statistics on market capitalization and interval since previous rating change are
weakly significant, and the coefficients are in the correct direction, the
coefficient values are extremely small, and do not constitute a large impact on
stock-related CAR. The coefficient on market capitalization indicates that an
additional US$100 million in market capitalization only increases the stock
related CAR by 0.062 % pts (but the average market capitalization for the entire
sample is only US$128.35 million), while the coefficient on interval since
71
previous rating change indicates that an additional 100 days interval since
previous rating change increases stock related CAR by only 0.075% pts. None
of the explanatory variables for positive credit watch are significant. The
regression for positive credit watch as a whole also has no explanatory power
with a low adjusted R square.

We note that investors may factor the state of the local MSCI country
index more heavily for negative credit watch because they condition the
probability that a downgrade will materialize on the state of the broader
countrys economy. However, for positive credit watch, it is possible that since
companies more actively disseminate good news, investors are already well
informed as to the possibility of a subsequent long term rating upgrade, and
hence do not condition as heavily on the state of the broader countrys
economy.

Additionally, for long term rating downgrades, there is also a more
negative reaction in developed markets. In the regression used, the t-statistic
on the developed markets dummy variable is -1.74, and the coefficient of -
0.01111 implies that, holding all else constant, the marginal effect of being
domiciled in an emerging market decreases the stock related CAR by 1.11
72
percentage points (i.e. more negative). As expected, downgrades that cross
the investment grade band have a more negative reaction than downgrades
that do not. The t-statistic on the investment grade transition dummy is -2.61,
and the coefficient value of -0.0168 implies that, all else being equal, rating
downgrades that cross the investment grade band to non investment grade
have a stock related CAR that is more negative (-1.68 % pts). We note that
although the t-statistics on market capitalization and interval since closest rating
change are weakly significant, the coefficient values are too small to have a
notable impact on stock related CAR.

Lastly, the regression on rating upgrades demonstrate that the
contemporaneous return on the local MSCI country index significantly impacts
stock-related CAR. The t-statistic of 2.42 is significant, and the coefficient of
0.0389 implies that, holding all else constant, the marginal effect of a 1% point
increase in the MSCI country index return results in a 3.89% pt increase in
stock-related CAR.

We note that MSCI country index returns is positively related to the stock
related CAR following negative credit watch, but does not significantly affect the
stock related CAR to positive credit watch. Conversely, MSCI country index
73
returns is positively related to the stock related CAR following long term rating
upgrades, but does not significantly affect the stock related CAR to long term
rating downgrades. The former is likely due to the fact that investors use the
state of economy to determine whether a subsequent downgrade is likely, whilst
the latter may be a result of the fact that long term ratings are forward looking
with a greater time horizon than credit watches; investors may condition their
reaction to good news on whether the broader economy is also performing well,
since this could affect the companys future good prospects in the long term.
However, the fact that investors do not do this for bad news (i.e. downgrades)
could indicate that all the bad news is already factored in. This could also
explain why being domiciled in an emerging market versus developed market
does not affect stock related CAR to long-term upgrades. In short, investors
primarily weigh broader market conditions most heavily in assessing potential
positive future prospects implicit in an upgrade.
74
11.4 Discussion of Insider Trading Prohibitions

With regards to insider trading, we note that the coefficients on the
insider trading laws enforced dummy and anti director rights index variable
indicates that the enforcement of insider trading laws increases the stock
related CAR to negative CW by -0.42% (more negative) for insider trading laws,
and by -0.07% for each point on the anti director rights index. However, both
coefficients have low t-statistics which are not significant at the 2.5% level of
significance. For long term downgrades, we note an increase of stock related
CAR to downgrades by -0.32% (more negative) and -0.06% for each point on
the anti director rights index. Once again, both coefficients are not significant at
the 2.5% level of significance.

We note that one possible explanation for the significant
preannouncement abnormal returns in emerging markets compared to
developed markets (for long term downgrades), but the absence of a significant
t-statistic for the insider trading law dummy in the regression could be the
relative lack of effective enforcement of insider trading regulations in emerging
markets compared to developed markets. That is to say, it is possible that
insider trading laws may not be entirely effective in preventing insider trading,
75
especially in emerging markets. There is some evidence for this in the
literature.

In Do Insider Trading Laws Work?, European Financial Management
Journal 05, Bris shows that profits made by informed corporate insiders before
tender offer announcements increase after new insider trading laws are first
enforced. The paper finds that laws that proscribe insider trading fail to
eliminate profits made by insiders. The prohibition then shifts the supply curve
for insider trading, and therefore raises its price; insider trading therefore
becomes more profitable after laws are introduced that prohibit it. Additionally,
law enforcement also raises the possibility of monopoly profits for anyone that
can find a way to circumvent the law.

These results are supported by existing literature that compare stock
related returns to events in developed and emerging markets. Bekaert &
Harvey 02 note in a paper Research in emerging markets finance: Looking to
the Future that emerging market equity returns have higher serial correlation
than developed market returns. This serial correlation is symptomatic of
infrequent trading and slow adjustment to current information (Harvey 95,
Kawakatsu & Morey 99), and therefore, emerging market returns are less likely
76
to be impacted by company-specific news announcements than developed
market returns. The paper suggests that insider trading occurs well before the
release of information to the public.

Additionally, in a paper entitled When an Event is not an Event: The
Curious Case of an Emerging Market, Jan 2000 Journal of Financial
Economics, Bhattacharya et al showed that shares trading in the Bolsa
Mexicana de Valores (Mexican stock exchange) do not seem to react to
company news. Using a sample of Mexican corporate news announcements
from the period July 1994 through June 1997, this paper finds that there is
nothing unusual about returns, volatility of returns, volume of trade or bidask
spreads in the event window. The authors then provide evidence that suggests
that unrestricted insider trading causes prices to fully incorporate the
information before its public release.

Bekaert & Harvey 02 also point out that there is literature on stock
selection in emerging markets that suggests that simple combinations of
fundamental characteristics can be used to develop portfolios with excess
returns to the benchmark (as demonstrated in Achour et al, 99, Fama &
French, 98, Rouwenhorst, 99, etc). Bekaert & Harvey 02 conclude that the
77
preponderance of evidence therefore suggests that emerging markets are
relatively less informationally efficient than developed markets.
78
11.5 Country Breakdowns

As a robustness check, we compute the average stock related CAR for
each country for long term rating upgrades / downgrades and positive / negative
credit watch (Table 14). We find that for long term rating downgrades in
developed countries, 90.9% of the developed countries in the sample have
negative stock related CAR upon long term rating downgrade, and 61.1% of the
emerging countries in the sample have negative stock related CAR upon long
term rating downgrade. Less than 50% of developed and emerging countries in
the sample have positive stock related CAR upon long term rating upgrades.

Table 14 shows that 78.3% of developed countries in the sample exhibit
an average stock related CAR that is negative after negative credit watch.
Additionally, 61.1% of emerging countries in the sample exhibit an average
stock related CAR that is negative after negative credit watch. 54.6% of
developed countries in the sample exhibit an average stock related CAR that is
positive after positive credit watch, and 53.9% of emerging countries in the
sample exhibit an average stock related CAR that is positive after positive credit
watch.
79
Table 14
Country
Stock Related CAR
Negative Credit
Watch Stock
Related CAR
Long Term
Upgrade Stock
Related CAR
Long Term
Downgrade Stock
Related CAR
AUSTRALIA -0.43% -1.19% -0.03% -1.46%
AUSTRIA -0.32% 0.04% 0.42% -0.52%
BELGIUM -0.32% 0.98% -0.32% -2.07%
BRAZIL 0.00% -1.48% 0.17% -1.00%
CANADA 0.08% -0.69% 1.23% -1.56%
DENMARK 1.82% 5.65% 0.00% -0.40%
FINLAND 5.84% -2.13% -0.66% 0.19%
FRANCE -0.54% -1.74% -0.20% -1.28%
GERMANY -0.06% -0.35% -0.14% -1.03%
GREECE 3.00% 1.00% 0.02% 1.21%
HONG KONG 0.00% -1.13% 0.32% -0.59%
IRELAND 0.69% -0.63% -0.06% -3.23%
ITALY 0.14% -1.07% 0.17% -1.00%
JAPAN -0.08% -1.76% 0.15% -0.69%
NETHERLANDS -0.07% -5.15% -0.09% -3.44%
NEW ZEALAND 0.28% -1.46% -0.50% -0.01%
NORWAY -1.15% -2.55% -0.18% -6.67%
PORTUGAL 4.52% 0.46% 0.21% -0.09%
SINGAPORE N/A -4.00% -0.15% N/A
SPAIN 0.14% -0.17% -0.28% -0.57%
SWEDEN 0.01% -1.85% -0.50% -0.43%
SWITZERLAND 1.69% -9.25% 0.07% -5.06%
UNITED KINGDOM 0.36% -1.72% -0.08% -1.75%
# of countries 22 23 23 22
# of countries with
average returns in the
correct direction (i.e. > 0
for positive watch and
upgrades, and < 0 for
negative watch and
downgrades)
12 18 10 20
% of countries with
average returns in
correct direction
54.55% 78.26% 43.48% 90.91%
Listing of average stock related CAR to Long Term Rating Changes from Moody's Investor's
Service and S&P Rating Agency
The combined sample of long term rating changes is broken down by rating type (upgrades or
downgrades) and country, with the average stock related CAR of long term rating events in each country
for that rating type listed. Overall country results are considered to be in the correct direction if the rating
type is a downgrade and the average stock related CAR for all rating types for that country is negative, or
if the rating type is an upgrade and the average stock related CAR for all rating types for that country is
positive. Emerging Dummy is 1 if the country is classified as emerging in the Morgan Stanley Capital
Index
Table 14 Panel A: Developed Markets

80

Country
Stock Related CAR
Negative Credit
Watch Stock
Related CAR
Long Term
Upgrade Stock
Related CAR
Long Term
Downgrade Stock
Related CAR
ARGENTINA -0.30% -1.28% 0.05% -2.87%
BRAZIL 0.01% 0.77% -1.28% -0.16%
CHILE N/A -0.15% -0.53% -1.00%
CHINA 3.40% -3.44% 1.71% 0.40%
HUNGARY 0.01% 0.13% -0.33% -0.23%
INDIA 0.83% -0.70% -0.08% 5.43%
INDONESIA -0.59% 0.61% -1.88% 0.90%
ISRAEL N/A -2.33% 2.00% 3.34%
KOREA -0.47% 0.53% 1.33% 2.36%
MALAYSIA -0.55% 0.52% -0.07% -1.09%
MEXICO -0.43% -2.30% 0.05% -1.48%
PHILIPPINES 2.75% 0.28% -1.06% -0.17%
POLAND N/A -12.23% -0.68% 7.29%
RUSSIA 1.39% 0.83% -1.03% -2.33%
SOUTH AFRICA N/A -0.83% N/A 3.00%
TAIWAN N/A -3.35% 0.20% -0.79%
THAILAND 3.77% -1.62% 1.26% -1.51%
TURKEY -7.00% -21.00% 1.45% -1.00%
# of countries 13 18 17 18
# of countries with
average returns in the
correct direction (i.e. > 0
for positive watch and
upgrades, and < 0 for
negative watch and
downgrades)
7 11 8 11
# of countries with
significant results (at
2.5% level of
significance)
2 4 1 4
% of countries with
average returns in
correct direction
53.85% 61.11% 47.06% 61.11%
Table 14 Panel B: Emerging Markets

81

12. CONCLUSION AND FUTURE DIRECTIONS

We examine the informational content of being placed on Moodys and
S&Ps watch lists using a comprehensive database of credit watch placements,
and also bond rating changes for non US domiciled companies. We analyze
the informational content in 3 ways first, we examine stock related CAR from
separate samples of credit watch placements and also bond rating changes
over a 3 days (-1, +1) window centered on the actual credit watch / rating
change on day 0.

Secondly, we examine the linked samples of credit watches that are
resolved by expected rating changes, and also the unlinked samples, where the
rating changes are unexpected. Thirdly, we analyze the samples by various
partitions, include emerging / developed markets, investment grade transition /
non-investment grade transition and state of local MSCI country index.

Being placed on a credit watch list is, by itself an informative event.
Additionally, negative credit watches appear to carry a greater informational
content compared to positive credit watches this could be due to the
82
explanation offered in Goh & Ederington (1993) that companies are more
proactive in disseminating positive news compared to negative news. Long
term rating downgrades on the whole also result in a significant negative stock
related CAR. Positive credit watch and upgrades on the whole generally do not
result in significant reactions.

Reactions to negative credit watch and long term rating downgrades are
generally less pronounced (i.e. more positive) for companies domiciled in
emerging markets compared to developed markets. This could be because of
greater information leakage (e.g. through insider trading, etc) in emerging
markets that result in bad news being disseminated more rapidly than in
developed markets. Additionally, surprised long term downgrades and
informative negative credit watches all result in stock related CAR that are more
pronounced (i.e. more negative) than expected long term downgrades and
uninformative negative credit watches the same is true for both developed
and emerging markets. Reactions to credit watches and long term rating
changes also appear positively related to the contemporaneous return on the
MSCI local country index. Lastly, long term rating downgrades that result in a
transition from investment grade to non-investment grade generally exhibit a
more negative stock-related CAR.
83
Going forward, it may be interesting to analyze average stock-related
CAR at the country level and also partitioned by national regulatory
characteristics at the aggregate level. This could help to identify which specific
national regulations that mandate corporate disclosure, regulate insider trading,
and enforce corporate transparency impact the additional informational content
that bond rating changes and credit watch provide to investors.
84
13. BIBLIOGRAPHY

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Issuers and Institutional Investors. Journal of Business Finance & Accounting,
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Mechanisms. The Review of Financial Studies, 19, 81 - 118.

Dichew, I. & Piotroski, J. (2001). The Long-run Stock Returns Following Bond
Ratings Changes. Journal of Finance, 56, 173 - 203.

Ederington, L. & Goh, J. (1998). Bond Rating Agencies and Stock Analysts:
Who Knows What When? Journal of Financial and Quantitative Analysis, 33, 569
- 585.

85
Ellis, D. (1998). Different Sides of the Same Story: Investors' and Issuers' Views
of Rating Agencies'. Journal of Fixed Income, 7, 35 - 45.

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effects of Moody's bond ratings changes on equity returns. Quarterly Journal of
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Hand, J., Holthausen, R., & Leftwich, R. W. (1992). The effect of bond rating
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Kaminsky, G. L., & Schmukler, S. L. (2002). Emerging Markets Instability: Do
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88

Norden, L., & Weber, M. (2004). Informational Efficiency of Credit Default Swaps
and Stock Markets: The impact of Credit Rating Announcements. Journal of
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89
APPENDIX A: THE BEHRENS FISHER PROBLEM

The Behrens Fisher problem involves interval estimation and
hypothesis testing on the difference of means of two normally distributed
populations, when the variances of the 2 populations may not be equal. We note
that it is assumed that the 2 populations are independent.

Behrens and Fisher proposed to find the probability distribution of
=
2 1
2 1
2
1
N N
S
X X
t
s
s
s

Fisher proposed initially that the distribution of this statistic can be
approximated by ignoring random variation in the relative sides of the standard
deviations, as in:
n
s
n
s
n
s
2
2
2
1
2
1
1
1
+

90

Welch (1938) approximated the distribution by the Type III Pearson
distribution, applying this to the following number of degrees of freedom:

( )
( ) ( ) 1 1
2
2
2
1
2
1
2
2 1
+
=
n n
v

where
ni
i
i
2
=

The null hypothesis would then involve the expectation of equality,

2 1
= , so the distribution of the Behrens Fisher statistic, T, which will also
depend on the variance ratio (of both distributions) can now be approximated by
the Students t distribution with v degrees of freedom.

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